Small-Cap Tech Names Cheap After Earnings

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Finding value in technology stocks isn’t easy. The industry is known for high multiples and very little forward visibility, which is why so many value investing legends like Warren Buffett or Seth Klarman typically avoid technology names.

Sometimes Mr. Market delivers opportunity, however. These two small-cap tech stars deserve a bid, even after recent earnings disappointments.

Investors dump hard drives

In the fourth quarter, Seagate (NASDAQ: STX) beat on the top and bottom line, posting earnings of $1.20 per share, above analyst estimates of $1.19. Sales beat by $10 million, for $3.43 billion during the quarter.

That wasn’t good enough for investors, however, as shares dropped by more than 8% after earnings.

Seagate suffered from what investors like to call a “tough lap” over last year. In the fourth quarter of 2012, Seagate sent twice as much to its bottom line and posted sales 33% higher than in the current quarter.

We shouldn’t be surprised that Seagate can’t keep up with earnings or sales from 2012. Last year's top-line was buoyed by a shortage of hard disk drives after a flood in Thailand. Temporary flooding and a loss of supply gave the two major players, Seagate and Western Digital, pricing power that allowed for margin expansion.

The economics of the hard disk manufacturing business are returning to normalcy.

As it turns out, normalcy isn’t all that bad. Seagate generated $394 million in operating cash flow, distributing $137 million to shareholders as dividends, and repurchasing nearly $42 million worth of stock. Going forward, the growth of the cloud should continue to drive hard disk sales as solid-state drives cost six times more than HDDs on a storage-per-dollar basis.

For the full year, Seagate earned $1.8 billion, which leaves Seagate to trade for just 8 times fiscal 2013 earnings. Given the company’s big discount to the market, I still think it’s worth a bid by value-oriented investors who like the big dividend yield of 3.78%. 

Money-making machines fall out

Outerwall (NASDAQ: OUTR) made a business of coin counting and DVDs by kiosk, but investors aren’t happy with its latest earnings report. The company’s strongest segment, Redbox, posted its second decline in same store sales of 6.8%.

That sent investors running for the exits, fearing that the company’s cash flows may quickly dwindle. Executives and analysts were quick to point out that declining revenue came during a period of weak Hollywood releases. Future quarters should fare better.

While Redbox’s second-quarter results were less than exceptional, the company has a new rock star kiosk in its product line, the ecoATM. Outerwall purchased the remaining 77% of the company it didn’t own during the quarter, and it has big plans in place for 2013.

ecoATM turns unused and broken phones into cash. With 650 installed kiosks in 2013, the company reports average revenue of $100-$120,000 per unit, at an all-in cost of $35,000 per unit. The supplemental slides reveal that the payback period is 14-22 months, suggesting that its margins are in the range of 15-20% on every device it purchases.

ecoATM is Outerwall’s next big hit. The company believes it could have as many as 800-900 ecoATMs in place by the end of 2013, which would generate at anywhere from $14.4-22.5 million in new free cash flow using Outerwall’s data. Given the quick 14-22 month payback period for units in malls, one would expect that ecoATM can be profitably placed in lower traffic areas.

EcoATM capitalizes on emerging trends in technology. Phones are lasting longer as upgrade cycles slow, increasing the sales value of older models, growing ecoATM’s core business. Meanwhile, only a small percentage of phones are currently recycled. The EPA suggests that only 18% of devices that can be recycled are recycled each year. Given that the company is still ramping up its installed base, it hasn’t made use of national advertising to drive traffic; the results are all organic. Given a modest marketing investment, ecoATM’s earnings could grow significantly.

At an equity value of 7 times free cash flow, Outerwall is a cheap stock with plenty of future opportunity.

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